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Investing Fundamentals

February 27, 2019

What's the IRR of Farmland?

IRR Defined

The Internal Rate of Return (IRR) is a commonly used method of calculating an investors' overall rate of return. The method is widely used in real estate and project-based investing, as it takes into account the investor's return without the influence of external factors such as inflation or the cost of capital. In the context of savings and loans, the IRR is often referred to as the effective interest rate.

Said differently, the internal rate of return is a general indicator of the profitability or overall annualized yield of an investment. While the actual rate of return that any given project ends up generating will often differ from its estimated IRR, a higher IRR is generally the goal. That being said, the risk an investor accepts in trade for a higher rate of return is a big deal.

The Historical IRR of Farmland

As discussed in our white paper, the average annual return of farmland for the last 25 years has been roughly 11%-12% according to the NARIEF index. Importantly, this has been with relatively little volatility and consistently positive returns: Screen Shot 2018-08-30 at 8.20.28 PM.png

This annual return is the combination of yield plus appreciation in land value. Though calculation of IRR over long time periods can become slightly complex, a decent rule of thumb we use for IRR regarding farmland is simply using this combination of yield and appreciation in land value.

How We Calculate Expected IRR

Given the combination of annual yield plus annual land value appreciation is a decent proxy for IRR, we use this to illustrate IRR given it is the simplest approximation of what an investor's overall return could be.

Annual Yield

Interestingly, annual yield is often the larger variable. This annual yield, or rent the landowner receives from the farmer, can vary based on commodity prices. While we seek longer-term leases with farmers (typically 3-5 years), over time, the underlying yield should represent expansion in commodity prices. Commodity prices like beans and corn often follow overall inflation. Thus, the attractive inflationary hedge of owning farmland.

In today's environment, due to exceptionally good farming weather for several years in a row, looming trade wars, low interest rates, and a myriad of other factors, commodity prices are relatively depressed. Thus, the yield on farmland is pretty low. However, as history has shown us, the upward trend in commodity prices should persist over time, and thus farmland yields may increase as well.

Despite this potential for increasing commodity prices over the long term, we assume the currently-depressed yields persist for purposes of our IRR calculation.

Land Value Appreciation

On top of annual yield is the growth in farmland value. As the table below shows, the Cumulative Average Growth Rate (CAGR) of farmland over the last 50 years has been relatively stable, regardless of the time period chosen. For our IRR calculation, we use the longest time period available from the USDA database, 50 years. Over that time period, the average annual value growth in farmland has been 5.4%. Screen Shot 2018-08-30 at 8.34.13 PM.png

An Example IRR

For an example of above, if we look at a fairly standard piece of farmland in the Midwest or the South, let's assume an annual yield of 3% and an annual growth in land value of 5.4%. The resulting IRR would be roughly 8.4%.

While this is a simplified view of IRR, and actual outcomes can vary widely vs. projections, this gives us an idea of the anticipated IRR. It is worth noting that this IRR was calculated WITHOUT assuming any debt. While debt can amplify an investment's anticipated returns, it is also a potentially dangerous mechanism, as noted in our post about leverage and debt.

Additional Note: The information above is not intended as investment advice. Data referenced herein is through year end 2017 and is sourced from Bloomberg, USDA Agricultural Land Values Survey, USDA Nominal Farmland Values, USDA Farm Sector Equity Assessment, and NCREIF, with additional calculations and analysis performed by AcreTrader. Past performance is no guarantee of future results. For additional risk disclosures regarding farmland investing and the risks of investing on AcreTrader, please see individual farm offering pages as well as our terms and disclosures.

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There are no guarantees in life, especially when it comes to investing. Recent surges in market volatility for stocks and bonds serves as a fresh reminder that asset prices don’t always go up. Can farmland save us?

In short: there are no guarantees in investing, and past performance is not a guarantee of future results. With that being said...

Farmland prices historically have no relationship with stock market returns and have offered a highly attractive way for investors to diversify their portfolios.

Farmland Prices and Stock Prices Move Independently

Look at the chart below showing the relative movement between United States farmland (the green line) and the S&P 500, a primary equities index (red line). What do you notice about the correlation between the two? pasted image.png

To be statistically precise, the correlation between these two asset classes is -0.03. Said differently, there is zero statistical evidence that stock market prices influence farmland prices and vice versa.

The lack of correlation alone suggests that farmland is a great portfolio diversification tool. In a world where most other asset classes increasingly move together, farmland helps mitigate the risk of financial loss in all assets at once. Additionally, the relative movement in the chart above demonstrates two other very important points.

  1. Stocks are volatile. Yes, this is known, but it is fascinating to see the annual gyrations between positive and negative annual returns from the stock market. Swinging between 30% returns and 40% losses isn’t for the faint of heart.
  2. Farmland is a much more stable asset class. Note that the volatility in the green line is just how much is made each year in farmland. Said differently, the returns of a farmland investment over time have oscillated between making small returns and large ones, not between huge profits and massive losses like the stock market saw in the early 2000’s or the great financial crisis. To learn more about the historical investment performance of farmland, please see the for investors section of our website. To learn more about our current offerings, please click here.

Note: The information above is not intended as investment advice. Data in the charts above is sourced from Bloomberg and NCREIF. Additional calculations and analysis performed by AcreTrader. Past performance is no guarantee of future results. For additional risk disclosures regarding farmland investing and the risks of investing on AcreTrader, please see individual farm offering pages as well as our terms and disclosures.

Can Farmland Protect You From Stock Market Volatility?

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Methods for Decreasing Farmland Investment Risk

Net cash farm incomes (take-home money for farm operators) have fallen over the last 5 years, but the price of farmland has remained relatively stable despite the downturn. Despite the stability, investors must think about protection during weak farm economies. Thankfully, many of the risks that can come with owning farmland during turbulent times can be resolved for investors with the right structures. Net_farm_income_and_net_farm_cash_income.png

Method #1: Cash Rent

Rental contracts for farmland vary widely between different regions. However, there are generally two categories of rent contracts: revenue share and cash rent.

Revenue share pays the landowner a percentage of the crop produced on his or her farm at the end of the year. While crop share arrangements can add a some additional upside to the returns, it also adds risk to the investment by giving the landowner 1) exposure to the farmer’s operational successes and failures (including weather risk), and 2) more direct exposure to commodity markets, since the land owner’s crop will have to be sold.

Cash rent is a lease paid to the landowner annually. Importantly, the rent is a fixed dollar amount per acre agreed upon in each lease (leases are typically 1-5 years).

Cash rent is the number most often discussed in farming circles and researched by the USDA; there is good data about state and county average rents, which allows investors to understand an individual farm compared to others around it.

For AcreTrader farmland investors, cash rent provides stability without an immediate link to commodities markets or weather risk. This allows investors to have regular, stable rental returns while allowing the land itself to appreciate over time.

Method #2: Diversification

Another source of stability is diversification of farm property. The more varied properties an investor can own the more likely the income stream will be stable. In any given year a property may be in an area where there is a drought or other weather related problems affecting production. As discussed above, this will generally not affect any given year’s rental income since the rent is negotiated at the beginning of the season. However, a series of problems in an area could reduce the frequency in which it is appropriate to raise rent alongside a farm’s typical productivity increases and economic inflation. In other cases, rent could even decrease.

Any property owner needs to work with farmers to make sure rent is fair to all parties. However, owning multiple properties reduces the risk that the entire portfolio could have these problems at the same time. AcreTrader provides a flow of different investment options to allow investors to build their own portfolios of land and decrease their own concentration risk.

Method #3: No Debt

farm_sector_solvency_ratios.png

Leverage creates a different problem for farmland owners. The fixed cost of a farmland payment can cause issues with the variable revenues farms often generate. For instance, if a farmland investor purchases land and cannot make his debt payments, then he risks losing his investment to the bank. For this reason debt ratios have been low since the 1980’s when many landowners held too much debt on their land.

The most stable investors and funds do not typically use debt to invest in farmland. Land can be purchased outright and should generate income from the investment in the first year with no risk of debt default.

For this reason, AcreTrader typically fully funds all of its deals at closing and places no debt on the subject property. Also, AcreTrader provides an alternative to debt for farmers: a farmer can bring a property to the platform that she would like to farm, but cannot purchase on their own. The farmer can then purchase a portion of the land (depending on what they can afford), sell the rest to investors, and lease the land to farm. This way, they can increase the size of operations, but without taking on the huge expense of land, while still gaining value from land appreciation.

Method #4: Long holding periods

arable_land_use_per_person.png One of the prime advantages of farmland is its ability to store value and appreciate over time. Unlike stocks which depend upon the underlying business’s ability to perform, farmland’s value depends upon the demand for food and the amount of land available to grow that food. As the world’s population increases and the amount of arable land decreases, land assets should grow in value. While there may be fluctuations in the price of farmland during small periods of time, over long periods of time the value has increased greatly. AcreTrader purposefully offers assets with longer holding periods to take advantage of this feature of farmland.

Method #5: Liquidity

That said, AcreTrader does understand that investors need the ability to get money out of an investment. This can be complicated in the case of volatile farmland prices. If the greater farmland market is doing well, but in one area there are no buyers, a landowner could have to wait a long time to find liquidity. Further, selling a farm can be tedious and complicated when owning farmland outright. AcreTrader can provide two solutions to this problem. First, we can provide investors for those wanting to sell land without buyers. Second, for investors needing liquidity, AcreTrader intends to provide the ability to sell shares in farms to other investors on the AcreTrader platform. This allows for liquidity in an efficient and cost effective manner for all involved.

Conclusion

Many factors can contribute to risk during a farm recession; however if investments are made with the factors above in mind, investors can help protect themselves during hard times. While prices can fluctuate in the near term, the AcreTrader platform provides structures and incentives that can help investors attain even more stability in an already highly-attractive asset class.

To see our current offerings, please click here.

Note: The information above is not intended as investment advice. Data referenced herein USDA and World Bank, with additional calculations and analysis performed by AcreTrader. Past performance is no guarantee of future results. For additional risk disclosures regarding farmland investing and the risks of investing on AcreTrader, please see individual farm offering pages as well as our terms and disclosures.

Mitigating Risk in Farmland Investments

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All things considered, time is our most valuable resource. We are all given a finite amount, and, unlike most resources, it cannot be recovered. To maximize the potential of this precious resource, we must be wise about how we invest both our time and hard earned money. Building passive income streams can be one of the best investments of both - eventually leading to financial freedom and greater control over your time.

Make money while you sleep

One of the greatest benefits of a passive income stream is that it requires very little effort to maintain and it generates automatic income. In contrast, active income streams often involve the direct exchange of your time for money. Most of us have to work to make a living. However, if we can only produce income while actively working, we leave ourselves exposed to the threat of being unable to earn in the event of an incapacitating injury or illness. If your goal is to achieve financial freedom and have greater control over your time, the more effort you put into expanding passive income streams the better. Not to say that this process will be easy nor require a short amount time to get started. No matter which passive income strategy you choose, you will likely have to invest significant amounts of time, earning little income in the beginning. But, keep in mind that after initial setup each income stream will continue producing income with little or no involvement, and in some cases, the underlying asset will continue to appreciate as well.

If you don't find a way to make money while you sleep, you will work until you die.

Warren Buffett

Diversify your portfolio

There are many ways to build passive income streams. Whether you are using your skills to make money online, investing for rental income, or in dividend stocks, you will be hedging your portfolio against more risky investments. However, the riskier investments typically have the potential for higher returns, so you likely wouldn’t leave them completely out of your portfolio either. The key is finding a balance to protect and maximize your portfolio value and sources of passive income are great at helping you achieve this. Diversifying your portfolio is a staple of good investment practices. You wouldn’t want to put all of your money in stocks because values can fall over 30% in a few months. By contrast, you wouldn’t want to place all of your money in bonds, even though they are less volatile. Your returns will be significantly lower than they could be if combined with investments in stocks. Experience shows that is best to have a mix of both, along with other asset classes like real estate. By also investing in non-correlated assets like farmland, which has historically increased in value when stock market values drop, you can provide balance to your portfolio and protect your overall earnings. In the end, the more you diversify your portfolio the less you expose yourself to risk. The right passive income streams are great tools for this because they typically offer low volatility, higher total returns than your standard “safe” investment, and generate income without active involvement.

Compound your earnings

The beginning of any passive income strategy is building a savings plan and sticking to it. Once you have a realistic idea of how much you need to make to cover your expenses, you can begin to look at additional income as fuel for the machine. This also gives you an idea of how much passive income will be needed to achieve your financial goals. As you continue to receive income from your day to day job and passive income streams, you can reinvest what you don’t need for your expenses to continue compounding its value. This takes discipline and dedication towards your goal, but over time is one of the greatest values of this strategy. The goal is to reach financial freedom, or the point at which you make enough passive income to cover all of your expenses. Not to say that passive income vehicles are the only way to get here. In fact, your investments should be diversified to protect you during different market cycles as mentioned above. However, having steady income outside of your primary job that you can use to make money while you sleep is a distinct advantage.

Conclusion

Passive income streams are crucial to your portfolio because they can generate predictable income with little maintenance, diversify your portfolio, and increase your overall cash flow. Remember, those who are the most successful are those who have the most control over their time. The more work you put into building passive income streams, the more control you will have over your precious time in the long run.

Learn more about the impressive diversification properties of passive farmland investments.

Note: The information above is not intended as investment advice. Analysis performed by AcreTrader. Past performance is no guarantee of future results. For additional risk disclosures regarding farmland investing and the risks of investing on AcreTrader, please see individual farm offering pages as well as our Terms & Disclosures here.

Why Are Passive Income Streams Important?